STEO Supplement: Why are oil prices so high?

During most of the 1990s, the West Texas Intermediate (WTI) crude oil price averaged close to
$20 per barrel, before plunging to almost $10 per barrel in late 1998 as a result of the Asian
financial crisis slowing demand growth while extra supply from Iraq was entering the market for
the first time since the Gulf War. Subsequently, as Organization of Petroleum Exporting
Countries (OPEC) producers more closely adhered to a coordinated production quota and
reduced output, crude oil prices not only recovered, but increased to about $30 per barrel as
demand grew as Asian economies recovered. The most recent increase in crude oil prices began
in 2004, when they almost doubled from 2003 levels, rising from about $30 per barrel at the end
of 2003 to peak at $56.37 on October 26, 2004. After falling back briefly, prices then continued
to rise in 2005 and 2006. In 2006, during much of May, June and July, WTI prices have
averaged above $70 per barrel. Adjusting for inflation, crude oil prices have not been this high
since late 1982. This supplement discusses the main factors contributing to high crude oil
prices.
1) Demand growth continues to outstrip non-OPEC supply growth. Increases in global
oil production capacity are struggling to keep pace with rapidly growing demand,
particularly in China, the other emerging economies in Asia, and the United States.
China alone accounted for one-third of the demand growth in the world from 2003 to
2005, and this trend is expected to continue during 2006. Despite oil price increases in
recent months, oil demand growth in major consumer countries has not slowed down as
much as many expected, as consumers have adjusted to higher oil prices. Annual
demand growth in 2004 was 2.7 million barrels per day (bbl/d), well over the previous
five-year average. Even as prices continued to rise in 2005, annual demand growth
totalled 1.4 million bbl/d. Oil demand continues to grow in response to continued
worldwide economic growth, particularly in China and the United States.
2) Non-OPEC supply has failed to meet expectations. Slower non-OPEC production
growth relative to demand growth has raised crude oil production expectations from
OPEC countries and has therefore lowered surplus production capacity (see Figure 1).
The largest detriment to non-OPEC supply growth in the last year has been Hurricanes
Katrina and Rita. From June 2005 to June 2006, hurricanes in the Gulf of Mexico cut an
average of 450,000 bbl/d of Federal offshore Gulf of Mexico production from the world
oil market in addition to damaging key refinery infrastructure. Most recently, EIA
estimates that production losses from the Prudhoe Bay field due to pipeline problems will
remove as much as 400,000 bbl/d from the market over the next several months. In the
rest of the world, pronounced declines in the North Sea and non-OPEC Middle Eastern
countries, delays in project start times, and unplanned field maintenance muted the small
growth in non-OPEC supply during 2005 and the first half of 2006. Russian production
was one of the major drivers of non-OPEC supply growth during the early 2000s. As the
investment climate worsened and oil prices continued to rise, the government raised
export and extraction taxes, adversely impacting production growth .

Energy Information Administration/Short Term Energy Outlook

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Figure 1. Demand Growth Exceeds Non-OPEC Supply Growth

28
Demand
Non-OPEC Supply*
WTI Crude Oil Price

3.5
3.0

Forecast

21

2.5
2.0

14

1.5
1.0

0.5
0.0

-0.5

$ Per Barrel Change from Previous Year

MMBD Change from previous year

4.0

Demand growth exceeds

non-OPEC supply growth

-1.0

-7

2003-Q1 2003-Q3 2004-Q1 2004-Q3 2005-Q1 2005-Q3 2006-Q1 2006-Q3 2007-Q1 2007-Q3

*Includes OPEC non-crude production, MMBD= million barrels per day

Source: Short Term Energy Outlook. August 2006

3) Low OPEC spare capacity levels increase the demand for inventories. EIA currently
estimates that global surplus crude oil production is about 1.0-1.3 million bbl/d, down
from 5.6 million bbl/d as recently as 2002 (See Figure 2). The reduced level of spare
production capacity significantly increases the risk to oil prices from a disruption to
supply because as many as 20 different countries currently produce at least 1 million
barrels per day, including countries such as Iran, Iraq, Nigeria, and Venezuela.

OPEC Spare Capacity (MMBD)

7.0
6.0

OPEC Crude spare

capacity has
decreased since
2002

1,000

950

5.0

900
Inventory building

4.0
3.0

850

2.0
800
1.0
750

ay

Ja
n

20
02
20
Se 0 2
p
2
Ja 002
n
2
M 0 03
ay
2
Se 00 3
p
2
Ja 003
n
2
M 0 04
ay
2
Se 00 4
p
2
Ja 004
n
2
M 00
ay 5
2
Se 00 5
p
2
Ja 005
n
20
06

0.0

OECD Stock Level (Thousand Barrels)

8.0

Figure 2. Low OPEC Spare Capacity

Leads to Crude Oil Inventory Building

Source: Short Term Energy Outlook. August 2006

With low spare capacity, market participants can no longer rely on increased production
from key members of OPEC to fully offset any supply disruptions and restore balance to
Energy Information Administration/Short Term Energy Outlook
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the market without the need for significant price changes, as they did in the 1990s and the
first few years of this decade. Since OPEC production capacity was forced to increase as
demand grew, OPEC spare capacity levels have been reduced even further. Industry
recognizes the need for new capacity investments, but those additions are costly and
sometimes come with a significant time lag.
In the present environment, with a minimal cushion of surplus upstream and downstream
capacity to meet disruptions in supply and with futures markets in contango (i.e., a
market in which prices for commodities delivered in future months are higher than for
those delivered in months closer to the present), market participants have a strong
demand for inventories, so the traditional inverse relationship between inventory and
price levels does not apply.
In Figure 3, low OPEC spare capacity levels are due mainly to demand growing faster
than production capacity, and crude oil inventory building has attempted to cushion
against the risk of further problems. Still, keeping in mind that between 2003 and 2005
word oil demand increased by 4.1 million bbl/d, as the inventory cushion grew, it resulted
in only 2 more days of forward cover.

Figure 3. Rising Demand Mutes Increase

in Days Supply Forward Inventory Cover

6.0

56
54

5.0

52

4.0
Days Supply

3.0

Spare Capacity

2.0

50
48

1.0

46

0.0

44

Days Supply

7.0

58
Days of supply increases by only 1.5
days from 2004 to present.

Ja
nM 02
ay
Se 02
p0
Ja 2
nM 03
ay
Se 03
p0
Ja 3
nM 04
ay
Se 04
p0
Ja 4
nM 05
ay
Se 05
p0
Ja 5
nM 06
ay
-0
6

OPEC Spare Capacity (MMBD)

8.0

Source: Short Term Energy Outlook. August 2006

4) Geopolitical issues in major OPEC producing countries have lowered production

and increased the risk of future production disruptions . In a market with tight spare
capacity and low forward cover in terms of days of supply, further risks introduced by
geopolitical instability in many OPEC, as well as non-OPEC countries put additional
upward pressure on crude oil prices. OPECs production has been primarily hurt due to
geopolitical instability in Iraq, Nigeria, Venezuela and Iran.
Iraq. Iraq is currently producing about 2.1 million barrels per day of crude oil,
and total liquids production of about the same amount. Over the past two years,
Energy Information Administration/Short Term Energy Outlook
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monthly Iraqi production has varied from a low of 1.6 million barrels per day to a
high of 2.3 million barrels per day, shifting largely as a result of security
issues/damage to infrastructure as well as weather conditions at Iraqi ports. Last
month, conditions improved to allow Iraq to export roughly 100,000 bbl/d via the
Kirkuk-Ceyhan pipeline. But in recent weeks the security situation in the north
has worsened, cancelling further exports through that pipeline.
Nigeria. Nigeria is the largest oil producer in Africa, with first half 2006 total
liquids output of approximately 2.5 million bbl/d, of which, 2.2 million bbl/d is
crude output. According to Shell around 500,000 bbl/d of its companys
production is currently shut-in as a result of militant action. Further disruptions in
late July have brought the total shut in volume to roughly 650,000 bbl/d. This
disruption has affected the Atlantic basin market since Nigeria traditionally
exports about 1.5 million bbl/d to the United States. Although new oilfields have
come online in the last six months, the crude quality is not as light and sweet as
the shut-in oil.
Venezuela. Venezuelas current crude oil production is about 2.5 million barrels
per day, with total liquids production of about 2.8 million barrels per day.
Venezuelas crude oil production since the strike of 2002-2003 has never returned
to pre-strike levels. Crude oil production averaged 3.0 million barrels per day in
2001, and that was before the full development of the four, foreign-operated ultraheavy oil upgrading projects that now produce 570,000 barrels per day. EIA
estimates that (Venezuelan state oil company) PdVSA-operated capacity has
fallen by 50 percent since the late 1990s, to about 1.4 million barrels per day at
present.
Iran. Iran, unlike Saudi Arabia, does not have any surplus production capacity
that could be brought online, i.e., the country is producing at the maximum rate
possible. Iran's existing oilfields have a natural decline rate estimated at 8-13
percent per year (300,000-500,000 bbl/d). Current investment levels are
insufficient to maintain, let alone expand, Irans production. In addition, the
uncertainty associated with the Iranian nuclear situation contributes to current and
projected high oil prices

5) Worldwide refining sector bottlenecks have raised refiner margins and have
implications for crude oil prices. Excess capacity in the refining industry, like that for
crude oil production, has been shrinking as demand has grown and has left less of a
buffer for emergencies or for periods when the supply and demand balance becomes
unusually tight. The 2005 hurricanes further emphasized the importance of the refining
sector. In the United States, refinery utilization is currently 92-93 percent of capacity, up
from 85 percent in 2002, but the reduction in excess refining capacity is not just a U.S.
issue.
Growing downstream tightness, especially in light, clean products for transportation, has
increased pressure on product prices beyond the effects of rising crude oil costs. As a

Energy Information Administration/Short Term Energy Outlook

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result, January-July 2006 US wholesale gasoline spreads1 are twice as high as the
January-July average for 2002-2005 (see Figure 4). In turn, the increase in refined
product spreads has generated increased demand for crude oil, thereby lending added
support to crude prices.
Figure 4. Strong Wholesale Gasoline Spreads
Encourage High Refinery Production
Gulf Coast Gasoline vs. WTI Crude Oil

140
120

Cents per Gallon

100

Jan-Jul. 2006:
32 cents/gallon

80
60
Jan.-July 2002-2005 Average: 16 cents/gallon

40
20
0
-20
Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Source: EIA calculations from Reuters spot prices.

6) Weather has disrupted supplies. As discussed briefly above, last years oil supply
disruption in the Gulf of Mexico severely hurt the prospects for non-OPEC supply
growth and had both short and long-term impacts on the WTI price. The Gulf of Mexico
region is an important source for U.S. production of crude oil and natural gas. In 2004,
crude oil production from the Federally-administered Outer Continental Shelf (OCS)
fields was about 27 percent of total U.S. production. Texas, Louisiana, Alabama, and
Mississippi also contribute significant onshore and State-administered offshore oil and
natural gas production. Seasonal storm-related disruptions to oil and natural gas
production are difficult to predict, primarily due to the uncertainty involved in predicting
the location and intensity of future tropical cyclones. Severe storms that threaten the
Gulf producing region do not happen every year, and long-lasting shut-in production
resulting from storm damage is generally rare. Last years hurricanes were an anomaly
that destroyed existing fields, transportation infrastructure, and projects under
construction. Many of these have only recently returned to operation or have been
significantly delayed. The possibility of another disruption this summer is an alwayspresent upward risk to EIAs price forecast.
7) Available evidence suggests that increased speculative activity in oil markets is a
symptom of, rather than a cause of, high oil prices. EIA analysts believe that the
change in the relationship between prices and Organization for Economic Cooperation
1

The wholesale price spread is the difference between the wholesale price of gasoline and the spot price of crude
oil.
Energy Information Administration/Short Term Energy Outlook
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and Development (OECD) commercial inventories is related to changes in the level of

surplus production capacity, which declined sharply due to the acceleration of global oil
consumption growth in 2003 and especially in 2004. Available evidence suggests that
increases in speculative activity in futures markets are a result of the high level of current
oil prices and the high uncertainty surrounding the value of future oil prices, not the other
way around. In times of ample spare capacity there is little motivation for commercial
producers and users of energy to shed risk, or hedge, since there is little perceived risk.
With little desire to shed risk, there is only a small role for those who wish to take on the
risk, the speculators. In contrast, when excess capacity declined and market participants
perceived that OPEC members would no longer maintain stable prices in the environment
of geopolitical risk, market participants became increasingly less certain of the path of
future oil prices. The increased uncertainty regarding the path of future oil prices has
caused commercial producers and users of energy to increase their desire to hedge. With
the increased desire to shed risk, there has been a much larger role in the market for those
prepared to bear this risk, the speculators. Although changes in the net position of noncommercial participants in WTI futures contracts appear to be in relation to changes in
WTI spot prices in the very short run, the overall trend of increasing WTI spot prices is
independent of the participation of speculators in the market.

100,000

$80

75,000

$70

50,000

$60
Net
Long

25,000

$50

$40

-25,000

$30

-50,000

$20
WTI Near-Month
Weekly Average Price

Net
Short

-75,000

$10
Apr-06

Jan-06

Jul-05

Oct-05

Apr-05

Oct-04

Jan-05

Jul-04

Apr-04

Jan-04

Jul-03

Oct-03

Apr-03

Jan-03

Jul-02

Oct-02

Apr-02

$0
Jan-02

-100,000

Nominal Dollars per Barrel

Number of Contracts

Figure 4. Changes in Speculative Activity Do Not

Explain Changes in WTI Prices.

Net Position of Non-Commercial Participants in WTI Futures Since 2002 vs. WTI Spot Price
Source: NYMEX Commitment of Traders Report, Commodity Futures Trading Commission. Graph
includes data up to May 2, 2006.

EIA believes that the shift in the relationship between prices and OECD commercial
inventories is better explained by changes in the level of surplus production capacity.
OPECs change in behavior that came as a response to the Asian financial crisis and
overproduction in the face of lower demand, shifted crude oil to a new price level.
Production restraint by key OPEC member countries shifted the price base while market
participants simultaneously perceived a growing likelihood or risk of increasingly scarce
incremental crude oil supplies. Futures market long-term contracts shifted up to a new,
higher, level of roughly $30, reflecting these new long-term expectations. Still, inventory
levels and crude oil spot prices continued their inverse relationship (i.e., falling
inventories correlating with rising prices), as shown by the January 2000-April 2004
Energy Information Administration/Short Term Energy Outlook
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trend line in Figure 6. Beyond April 2004, there is an apparent reversal in the
price/inventory relationship. While the correlation is not strong, prices appear to increase
with increasing inventories, as shown by the May 2004 to March 2006 trend line in
Figure 6. This fact alone appears confusing to some observers, who may attribute this
shift to the activity of speculators.
.
Figure 5. Traditional Inverse Relationship Between WTI
and Inventory Levels No Longer Exists.
$70

Dollars per Barrel

$60
$50
1992-1999
January 2000 - April 2004
May 2004 - March 2006

$40
$30
$20
$10
$0

2.3

2.4

2.5

2.6

2.7

2.8

2.9

Billion Barrels of Inventory

Sources: Reuters database and International Energy Agency database, May 2006.

Several different factors have caused the increase in crude oil prices since 2002. The disconnect
between non-OPEC supply growth and rising demand growth has raised production expectations
from OPEC suppliers at a time when geopolitical uncertainty inside of OPEC-member countries
is at heightened levels. The increased upstream risk has combined with constraints in the
downstream to hinder the smooth provision of available supply to demand centers. Weather
anomalies have created an added risk to oil production in hurricane-prone regions, and the weak
US dollar has masked the oil price rise in some regions that would otherwise have induced lower
oil demand. The new role of speculative money in the market is more a function of a shift in the
inventory and price relationship shown in Figure 6.
Given these factors, EIA does not foresee a relaxation of these trends through the short-term
forecast period, as long as OPECs spare capacity cushion remains at current levels. Although
next years oil supply balance may change with higher volumes of non-OPEC supply, these
additions are still prone to project delays, cost overruns, and weather anomalies that have hurt
production in the past.
Contact:
Michael Cohen
Michael.cohen@eia.doe.gov
(202) 586-7057

Energy Information Administration/Short Term Energy Outlook

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